Spread Trading Part 4: Connecting the Dots

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By
Thomas Preston

October 1, 2013

Fredrik Broden

If you’ve followed thinkMoney® through various discussions, you know that trading options is more than just being bullish or bearish or market neutral. There’s volatility. Limitations on capital. Stronger or weaker directional biases. Whatever the scenario, you always have the choice of a logical option strategy that is likely to be less risky, less capital intensive, and/or have a higher probability of profit than simply buying or shorting stock.

It may have seemed like a tall order, but consider yourself officially smart about options. Now that you have the knowledge, you should be able to look at choosing a strategy as a series of binary decisions based on three primary variables:

1—Volatility: high or low

2—Trend: bull, bear, or neutral

3—Time: shorter or longer term

The following is a grid of strategies, each designed to take advantage of a combination of these three variables. Used as a reference, this might help you run through the process of making speedy trading decisions should you need or want to. While you’re learning them, notice how most of them are composed of the basic vertical and calendar spreads.

High-Volatility Trades

Typically, high vol means higher out-of-the-money (OTM) option prices, which you can take advantage of with short premium strategies. High vol lets you find further OTM options that offer high probabilities of expiring worthless and potentially higher returns on capital. Pushing short options further OTM also means that strategies have more room for the stock price to move against them before they begin to lose money. Here are a few bullish, bearish, and neutral strategies designed for high-volatility scenarios.

Bullish Strategy No. 1: Short Naked Put

FIGURE 1: SHORT NAKED PUT OPTIONFor illustrative purposes only.

STRUCTURE: Sell put

CAPITAL REQUIREMENT: higher

RISK: Technically defined, but very high, depending on stock price

Consider looking for OTM options that have a high probability of expiring worthless and high return on capital. Capital requirements are higher for high-priced stocks, lower for low-priced stocks. Account size may determine whether you can do the trade or not. You can look for expiration in the short premium “sweet spot” around 30 to 40 days out to help balance growing positive time decay with still-high extrinsic value. Choose a stock you’re comfortable owning if the stock drops and short put is assigned. If that happens, you might want to consider selling calls against long stock to reduce cost basis further.

Consider using when the capital requirement of short put is too high for your account, or if defined risk is preferred. Target credit for short vertical 30% of width of strikes (i.e. $0.30 if the strikes are $1 apart). Consider looking for expiration in the short premium “sweet spot” around 30 to 40 days out. Create by looking for OTM put that has high probability of expiring worthless, then look at buying further OTM put to try to get target credit, typically one or two more strikes OTM.

Target the credit of the trade at 30% of the difference between strikes (i.e. $0.30 if the strikes are $1 apart). Consider looking for expiration in the “sweet spot” around 30 to 40 days out. Create by looking for OTM call that has high probability of expiring worthless, then look at buying further OTM call to try to get target credit, typically one or two more strikes OTM. Takes advantage of flatter vol skew on upside strikes.

Bearish Strategy No. 2: Long Unbalanced Call Butterfly

CAPITAL REQUIREMENT: lower, depends on difference between long and short strikes

RISK: defined

Combination of short call OTM call vertical and long at-the-money (ATM) or slightly OTM call butterfly. This should be a credit spread, where the credit from the short vertical offsets the debit of the butterfly. This is not aggressively bearish, as max profit is achieved if stock is at short strike of embedded butterfly. But if an unbalanced call butterfly is done for credit, it should not lose money if the stock drops and the entire position expires worthless.

Neutral Strategy No. 1: Iron Condor

FIGURE 5: IRON CONDORFor illustrative purposes only.

STRUCTURE: Sell lower-strike put vertical, sell higher-strike call vertical; distance between long and short strikes same

CAPITAL REQUIREMENT: lower, depends on difference between strikes

RISK: defined

Target the credit of the trade at 35% of the difference between long and short strikes. Look for expiration in the short premium “sweet spot” around 30 to 40 days out to balance growing positive time decay with still-high extrinsic value. Higher vol lets you find further OTM calls and puts that have high probability of expiring worthless but with high premium. Create iron condor by buying further OTM options, usually one or two strikes. Don’t do for too-small credit no matter how high the probability because commissions on 4 legs can eat up most of potential profit.

Max profit is achieved if stock is at short middle strike at expiration. Can place short middle strike slightly OTM to get slight directional bias. Probability of profit usually under 50% due to narrow profit range of long butterfly. High volatility keeps value of ATM butterflies lower. Butterflies expand in value most rapidly approaching expiration, so look at options 14 to 21 days to expiration. Short gamma increases dramatically at expiration (i.e., increases the magnitude of the options change in value) if the stock is at the short strike. Consider taking profit—if available—ahead of expiration to avoid butterfly turning into loser from last-minute price swing.

LOW–VOLATILITY TRADES

Lower vol usually means lower option premiums. That makes credit strategies less attractive—but all debit strategies are not created equal. Forget about straight long options for the moment. You might look for debit strategies where time decay is positive (i.e., time decay is working for, not against, your trade). Keep position size small. Add duration to strategies with further expirations to give stock some time to move in favor of the strategy. The following are some ideas for strategies designed for lower-volatility environments.

Bullish Strategy No. 1: Long ATM Call Vertical

Consider creating vertical where the debit is less than the intrinsic value of the long call. That will make time decay positive for this debit position. Look at expirations 30 to 60 days out to give position more duration. Max profit is usually achieved close to expiration, or if vertical becomes deep in-the-money (ITM). Consider taking less than max profit ahead of expiration if available.

Bullish Strategy No. 2: Long OTM Call Calendar

Because calendars maximize their value when the stock is at the calendar’s strike price near expiration, this bullish strategy has a “up to this price, but not much more” bias. Lower vol can make calendar debits lower. Look for short option between 25 and 40 days to expiration, and long option between 50 and 90 days to expiration. Look for calendar that can be profitable if stock stays at current price through the expiration of the front-month option and have approximately 1.5x debit price for max profit if stock is at strike price at expiration.

Bearish Strategy No. 1: Long ATM Put Vertical

You can create verticals where the debit is less than the intrinsic value of the long put. That will make time decay positive for this debit position. Look at expirations 30 to 60 days out to give the position more duration. Max profit is usually achieved close to expiration, or if vertical becomes deep ITM. Consider taking less than max profit ahead of expiration if it’s available.

Bearish Strategy No. 2: Long OTM Put Calendar

Because calendars maximize their value when the stock is at the calendar’s strike price near expiration, this bearish strategy has a “down to this price, but not much more” bias. Lower vol can make calendar debits lower. Put calendars can benefit from increase in vol if it increases on drop in stock price. Look for short option between 25 and 40 days to expiration, and long option between 50 and 90 days to expiration. Look for calendar that can be profitable if stock stays at current price through the expiration of the front-month option and have approximately 1.5x debit price for max profit if stock as at strike price at expiration.

Neutral Strategy: Short Straddle

FIGURE 11: SHORT STRADDLEFor illustrative purposes only.

STRUCTURE: sell ATM put, sell ATM call

CAPITAL REQUIREMENT: high

RISK: undefined

Shorting ATM call and put can generate large credit even in low vol, but requires greater confidence that stock price will not change much. Consider selling options closer to expiration—between 20 and 35 days—to maximize positive theta, and buying back the short strangle before expiration if profit is available.

“Money” Jargon

Out of the money (OTM): An option whose strike is away from the underlying equity. For calls, it’s the strike that is higher than the underlying. For puts, it’s the strike that’s lower.

At the money (ATM): An option whose strike is the same as the price of the underlying equity.

In the money (ITM): An option whose strike is inside the price of the underlying equity. For calls, it’s the strike that is lower than the price of the underlying equity. For puts, it’s the strike that is higher.

Spreads, straddles, and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.

A covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase. Additionally, any downside protection provided to the related stock position is limited to the premium received. (Short options can be assigned at any time up to expiration regardless of the in-the-money amount.)

The risk of loss on an uncovered call option position is potentially unlimited since there is no limit to the price increase of the underlying security.

The naked put strategy includes a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower.

Naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.

Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.